03 Feb “Take It Easy”

While the title may raise a few eyebrows given the equity market’s rocky start to 2016, its inspiration is Glenn Frey, the legendary singer-songwriter for the Eagles, who passed away on January 18, 2016. “Take it Easy,” cowritten by Frey, was the Eagles’ first single and one of their biggest hits. As an Eagles fan, I headlined this post with the song’s title both to pay tribute to the great Glenn Frey and to capture my thoughts about recent market turbulence and the danger of extrapolating too much information from a month of performance.

Can a month forecast the year’s performance?

To be clear, the markets face a number of challenges:questions about Federal Reserve policy in the year ahead, continued stress in the energy sector, the global implications of a slowdown in China. These and other issues have rattled markets lately and will in all likelihood command our close attention as 2016 progresses.

But it would be a mistake to conclude that a rough January tells us much about how the year will unfold. Even as we’ve enjoyed strong equity returns in recent years, we’ve often experienced surprisingly weak Januaries. The chart below shows U.S. stock market returns for both January and the rest of the year in each of the last 15 years. Clearly, in recent history,January returns alone have not been a great predictor of the year to come.

It’s not just January that has proved a poor predictor. The next chart displays the relationship between the returns in anyone month and the return for the rest of the year from 1928 through 2015. The plot shows that there’s almost no relationship between the one-month and rest-of-year returns. The diffuse scatter plot cautions us against using a month of performance such as this year’s rough January alone to draw conclusions about how the year will evolve.

The findings from the two charts should not come as a surprise given the nature of equity returns, which do not accrue in a linear or incremental fashion. And even if the equity market’s performance in a single month can’t tell us much about the rest of the year, it reminds us both to expect higher volatility in equity returns relative to an asset class such as fixed income and to expect that the volatility of volatility—the changes in volatility from one period to the next—will be higher as well.

Mitigating“big-number shock”

As equity markets gyrated through the first few weeks of January, media coverage raised the risk of “big-number shock.” Daily swings of hundreds of points in the Dow Jones Industrial Average seem to create a sense of crisis.

But it’s important to remember that the big numbers are a function of the significant growth in equity markets and equity indexes over the decades. Although a 100- , 200-, or 300-point swing in the Dow can make for an attention-grabbing headline, such triple-digit moves are neither rare nor out of character historically.

To guard against big-number shock, look at price movements in percentages rather than points. As of January 26, for example, a 162-point swing in the Dow amounted to a price change of 1%. Two decades ago, a 1% price swing was a move of just 53 points, a less eye-catching number. (As of January 26, a 1% move in the S&P 500 was 19 points; 20 years ago it was 6.)

It’s also useful to remember that we’ve been living through a period of unusually low volatility, which may have left us unaccustomed to normal equity market turbulence. Prior to August 2015, it had been nearly four years since the U.S. equity market declined 3% or more in a day. Since the 1950s, however, we’ve seen declines of greater than 3%, on average, roughly every eight months. The chart below shows the distribution of daily returns as a percentage of trading days in each decade. Rather than viewing these occasionally sharp movements (whether positive or negative) as abnormal, it would be reasonable to consider them part of the expected patterns of equity market performance.

“Don’t let the sound of your own wheels drive you crazy”

The message here is not to discount some of the thorny questions investors will grapple with in the year ahead; rather, it’s to remind us of the importance of having informed expectations about market volatility.As coverage of every market movement and event crescendos, it’s every bit as important to know what to tune out as what to tune in.

To paraphrase Glenn Frey, we should take it easy in areas where we have little or no control—changes in investor sentiment, the market’s volatile swings from day to day, the latest forecasts from prognosticators. We can take it easy and refuse to react to these developments based on emotion.

We can spend our time and efforts more productively on investment decisions that we can control: our asset allocation, our level of diversification, our investment costs, our saving and spending patterns. We can invest with an advisor who can provide guidance and coaching in periods of market stress.

As we’re running down the road in 2016, we can choose to put emotion aside, broaden our perspective, and “take it easy.”